Floor & Decor: Cracks In The Floor (NYSE:FND)

In April of last year, I believed it was time for shares of Floor & Decor (NYSE:FND) to find a floor as shares saw a painful reversal in their share price, even as the company guided for a strong 2022. Investors rightfully feared higher inflation, interest rates, and cooling of the (housing) economy.

Still believing that the secular long-term growth story remained intact, appeal was on the increase, as I indeed held a position for a brief period of time this summer, but I fail to see appeal here at this moment.

A Strong Franchise

Since the company went public in 2017, I have been an admirer of the company. At the time, Floor & Decor operated 87 stores, which offered low-priced floors with in-stock availability and a broad range of offerings. At the time, a $1.4 billion business, shares started trading around the $30 mark. These were high valuations with earnings power trending at just $0.70 per share in 2017, yet the potential was there. It was the high expectations which made that shares were trading range-bound between $25 and $50 until the outset of the pandemic.

Through 2019, the company has grown to a $2 billion revenue base as earnings topped the dollar per share mark, with valuations very gradually coming down. The company guided for 2020 sales at $2.5 billion and earnings around $1.30-$1.40 per share, ahead of the pandemic. After an initial setback, the company delivered on its promises as full-year sales of $2.4 billion came in touch light, offset by a stronger $1.50 earnings per share number that year.

Shares rallied to the $100 mark by year-end 2020 as investors were pricing in the benefits of the pandemic, as valuations became too high for me. Shares even hit the $150 mark in 2021 but fell back to $80 in April 2022.

2021 sales rose another 41% to $3.4 billion as the company has grown the store base to 160, essentially having doubled since the time of the IPO. Operating margins rose a full point to 9.9% of sales, with adjusted earnings per share up 62% to $2.44 per share. With the growth outlook becoming more challenged amidst tough comparables and genuine headwinds, the company guided for 2022 earnings to rise to $298-$325 million, up modestly from a $283 million profit number posted in 2021.

Pegging earnings power at $3 per share in 2022 valuations had compressed from about 50 times earnings to about 27 times earnings, marking a huge pullback in the valuation, but still a premium valuation, nonetheless. To offset the impact of a tougher 2023, the company guided for more growth in the medium term, targeting earnings to come in between $4.00 and $4.50 per share in 2024.

Given all of this, I was gradually becoming more upbeat on Floor & Decor, believing that a premium valuation is warranted given the long-term positioning and performance of the business. With shares back to $80 in April, I was looking to initiate again in the seventies as shares fell to the $70 mark in May as I sold the summer rip in the eighties, as shares even hit the $100 mark in the summer. Ever since shares have come down a bit again, now trading at $70 per share again.

What Happened?

Since my upbeat take on the stock in May, Floor & Decor has continued to show decent growth. Second quarter sales rose 27% to $1.09 billion, driven largely by store openings but a decent 9% organic increase in sales as well. That is the good news as margins took a beating with diluted earnings up just three cents to $0.76 per share. All of this is due to gross margin pressure, with operating expenses actually coming down as a percentage of sales. Following margin pressure, the company cut the full-year earnings outlook to $2.65-$2.80 per share.

Third quarter results were solid again on the top line, with comparable sales up more than 11%, driving total sales growth to more than 25%. Adjusted earnings rose ten cents to $0.70 per share, with the company narrowing the earnings guidance further to $2.65-$2.75 per share.

Given the lower profitability, higher inventories, and net capital spending requirements to drive business growth, the company has been incurring some net debt. Net debt now stands at $365 million, still a modest amount given an expected $570 million EBITDA metric seen this year. Net capital investments are still huge with capital spending seen around $450 million this year, coming in at roughly triple the depreciation expense of $150 million. The net capital investments into new stores actually exceed earnings power, let alone the working capital requirements of these stores.

Right now, the company trades at 25-26 times earnings as earnings estimates fall short by about 10% of the initial guidance. Given this dynamic, higher interest rates and poor working capital resulting in modest net debt here, I see no reason to get involved with Floor & Decor just yet. Given the tougher environment, I am reducing my entry point to $60 here, recognizing that this is still a great long-term business, albeit one which likely faces a tough 2023.